Disclosures and Transparency in Managing Climate-related Financial Risks

Background: The Basel Framework

The Pillar 3 disclosures under the Basel Framework complement Pillar 1 (minimum risk-based capital requirements) and Pillar 2 (supervisory review process) and are designed to promote market discipline by providing transparent, high-quality information regarding a bank’s business and its risks to all interested parties (including investors) on a consistent and comparable basis. The Basel Committee on Banking Supervision (henceforth, Basel Committee or BCBS) has laid down five guiding principles for banks’ Pillar 3 disclosures, viz., clarity (understandable to key stakeholders); comprehensiveness (covering bank’s main activities and all significant risks); meaningfulness (highlight a bank’s most significant current and emerging risks and how those risks are managed); consistency over time (enable key stakeholders to identify trends in a bank’s risk profile across all significant aspects of its business); and comparability across banks (should enable key stakeholders to perform meaningful comparisons of business activities, prudential metrics, risks and risk management between banks and across jurisdictions).

The Basel Committee considers that climate-related financial risks can materialise through the traditional financial risk categories (such as credit, market and operational risks) and, therefore, can be addressed within the existing Basel Framework. The climate-related financial risks are defined by the Basel Committee in its latest (April 2024) revision of The Core Principles for Effective Banking Supervision, as follows: “The climate-related financial risks refer to the potential risks that may arise from climate change or from efforts to mitigate climate change, their related impacts and their economic and financial consequences. Climate-related physical and transition risk drivers can translate into traditional financial risk categories such as credit, market, operational, liquidity, strategic and reputational risks. Climate-related financial risks can materialise over different time horizons, which may go beyond a bank’s traditional capital planning horizon.” The Core Principles, implemented by all jurisdictions for all banks, promote a principles-based approach to improve the management of climate-related financial risks by banks and their supervision by the supervisory authorities.

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Basel Committee’s Consultative Document: Disclosure of climate-related financial risks

On 29 November 2023, the Basel Committee issued a consultative document on bank-specific Pillar 3 disclosure requirements for climate-related financial risks (henceforth, ‘consultative document’) as part of its holistic work on regulation, supervision and disclosure of climate-related financial risks. Based on the feedback received (67 comments from various stakeholders), the Basel Committee will publish the final version of the document. The proposed climate risk disclosures have a reasonable level of flexibility and are likely to evolve as the collection and methodologies for compiling climate-related data mature and gain more sophistication over time.

The Basel consultative document draws upon the work of The Task Force on Climate-related Financial Disclosures (TCFD) and The International Sustainability Standards Board (ISSB). The Financial Stability Board set up TCFD to develop recommendations on climate-related financial disclosures by companies to enable investors, lenders, and insurance underwriters in assessing and pricing of climate-related risks. TCFD recommendations were voluntarily implemented globally by thousands of companies. In June 2023 the ISSB established by the IFRS Foundation, issued two standards – IFRS S1: General Requirements for Disclosure of Sustainability-related Financial Information and IFRS S2: Climate-related Disclosures. ISSB Standards require companies to provide sustainability- and climate-related information alongside financial statements – in the same reporting package. The Standards are built upon the concepts that underpin the IFRS Accounting Standards, implemented by more than 140 jurisdictions. The FSB has asked the IFRS Foundation to take over monitoring the progress of companies’ climate-related disclosures and accordingly, the TCFD was disbanded in October 2023. Several jurisdictions have adopted or have plans to adopt the ISSB Standards, viz., Canada, US, Costa Rica, Brazil, UK, European Union (EU), Nigeria, Turkey, India, Bangladesh, Singapore, Hong Kong, Malaysia, Philippines, Korea, Japan, Australia, New Zealand, etc. 

IFRS S1 defines sustainability in broad terms to encompass climate change, biodiversity, oceans, desertification and human rights. Its scope includes social and ecological communities; current and future generations; environmental and social notions of justice, health, welfare and preservation; and planetary boundaries. Both IFRS S1 and IFRS S2 mandate disclosures on opportunities and risks relating to sustainability and climate change, respectively. The Basel consultative document, on the other hand, focuses only on the risks: climate-related financial risks. While the ISSB Standards are aimed primarily at investors of companies, the Basel consultative document, specifically designed for banks, focuses on disclosures to promote market discipline as a part of the prudential supervisory framework. ISSB primarily focuses on the needs of the investors in defining ‘materiality’ or a material information requiring disclosure. Although the Basel Committee requires banks to disclose material information primarily from a risk and capital adequacy perspective, it also mandates that the exposures and financed emissions relating to 18 TCFD sectors should be disclosed regardless of materiality assessment. These sectors have the highest likelihood of climate-related financial impacts through constraints on greenhouse gas emissions, effects on energy production/use, and effects on water availability, usage and quality.

As shown in Diagram 1, the Basel consultative document adheres to the Basel III Pillar 3 methodology of requiring disclosure in Tables (qualitative) and Templates (quantitative).

The consultative document requires banks to disclose (i) qualitative aspects relating to governance, strategy and risk management of climate-related financial risks (Table CRFRA); and (ii) qualitative aspects relating to transition risk, physical risk and concentration risk (Table CRFRB). The qualitative disclosures are sufficiently comprehensive and meaningful, therefore providing a forward-looking perspective. The disclosures on governance relate to the management’s oversight of climate-related risks. The consultative document seems to be more tentative (and has sought feedback) regarding disclosure of strategy for reducing and/or mitigating climate-related financial risks including through disclosure of forward-looking quantitative metrics comprising forecasts (ISSB uses the term ‘targets’) and transition plans. It requires disclosures on the organisation of the risk management function and the processes and procedures for the identification, assessment and management of climate-related financial risks. Banks must disclose their role in managing transition risk, exposure to chronic and acute physical risks and concentration risks (e.g., concentrations in vulnerable industry, economic sectors and geographical regions).

The quantitative disclosures of exposures relate to (i) physical risk and (ii) transition risk, as shown below:

1. Physical risk –

• exposures subject to physical risk: gross carrying amount of exposures (e.g., corporates, loans collateralised by commercial or residential real estate) subject to chronic and acute physical risk events, together with related non-performing exposures, allowances and maturity are to be disclosed.

2. Transition risk-

• exposures and financed emissions by sector – financed emissions relate to counterparty-reported emissions and proxy measures (based on physical activity-based emissions or economic activity-based emissions) for all on-balance sheet exposures of banks. The greenhouse gas emissions (GHG) are to be measured as per the Greenhouse Gas Protocol Corporate Standard and expressed as metric tonnes of CO₂ equivalent. Banks are required to disclose financed emissions for all material sectors but the 18 TCFD sectors are to be disclosed regardless of materiality.

• real estate exposures in the mortgage portfolio by energy efficiency level (subject to jurisdictional discretion) – the value of a mortgaged property could be negatively impacted if it is not in compliance with the energy efficiency requirements at the national level. Accordingly, this disclosure might enable market participants to assess risk profile and returns of a bank’s mortgage-backed real estate portfolio.

• Emission intensity per physical output and by sector (subject to jurisdictional discretion) – the emission intensity metrics could provide market participants with useful context and comparability as opposed to only absolute emissions. BCBS recognises this metric may pose challenges where banks have difficulty in obtaining this data from their counterparties.
  
• Facilitated emissions related to capital markets and financial advisory activities by sector (subject to jurisdictional discretion) – facilitated emissions refer to the gross emissions of a counterparty attributed to capital markets and financial advisory services (e.g., equity underwriting, securitisation, etc.) to that counterparty. Partnership for Carbon Accounting Financials published a calculation method for facilitated emissions in December 2023. Calculation and disclosure of facilitated emissions could be quite complex.

Feedback on the Consultative Document

The 67 comments received on the consultative document reflect a wide diversity of views. Opinions range from those who felt the proposed disclosures were not consistent with the objectives of Pillar 3 of the Basel Framework, to those who support the Basel Committee proposals and suggest additional disclosures, including those related to nature-related financial risks.

Organisations such as American Bankers Association, Bank Policy Institute, The Canadian Bankers Association, Institute of International Finance (IIF), Japanese Bankers Association, UK Finance, etc. argue that the Pillar 3 disclosure requirements, introduced as a part of the Basel II framework, promote market discipline by mandating certain specified disclosures of risk exposures, risk assessment processes and the capital adequacy of banks. Furthermore, the Pillar 3 disclosures differ from confidential regulatory reporting, are narrower than corporate disclosures, and focus on ‘material information’.

It is argued that the proposals in the consultative document are inconsistent with the stated objectives of Pillar 3 disclosures. They treat climate risk as a standalone risk type rather than a risk driver and should not duplicate corporate disclosure requirements in a Pillar 3 context. Regarding specific comments on qualitative disclosures (Table CRFRA), it is argued that disclosing strategic risks may be appropriate for corporate disclosure but is not relevant for Pillar 3 disclosure which focuses on banks’ risk profile and capital adequacy (the Basel Framework explicitly excludes strategic risk from its definition of operational risk). Currently there are no Pillar 3 disclosure requirements for business strategy and planning for factors such as pandemics, potential recession, emerging markets business risk, etc., and climate risk should be treated similarly.

Furthermore, it is argued that requesting banks to disclose financed emissions (Template CRFR1) or facilitated emissions (Template CRFR5) as a proxy of banks’ transition risk is inappropriate. Aggregate portfolio-level financed emissions metrics are not direct measures of transition driven financial risk to a bank. Therefore, characterising emissions disclosure as reflecting a bank’s financial risk exposure would be misleading to market participants. Additionally, the proposed physical climate risk metrics (Template CRFR2) are not meaningful indicators of a bank’s financial risk exposure. There is limited availability of consistent and comparable data on real estate properties’ energy efficiency (Template CRFR3) in many jurisdictions, impacting the relevance and meaningfulness of such disclosures. Moreover, forecasts of Financed Emissions (CRFR1 and CRFR4) are part of strategy, which is outside the Scope of Pillar 3 Framework. To sum up, it is argued that more BCBS work is needed to substantiate how the proposed disclosure is necessary to achieve Pillar 3 objectives.

Other institutions such as CDP, Fitch Ratings, I4CE, Positive Money, Reclaim Finance, Sustainable Finance Lab, etc., support the proposals in the consultative document. According to them, the proposed framework will help market participants to better understand climate-related exposures and related financial risks. A global Pillar 3 prudential standard will avoid fragmented disclosures and facilitate a comparison and assessment of banks’ relative exposure to climate-related financial risks. Additionally, they suggest that disclosures should not only include climate-related financial risks, but also ESG risks and nature-related financial risks as climate change impacts nature and the environment as well. 

Conclusion

The consultative paper has evoked strong reactions and there seems to be a pushback from the banking industry regarding the proposed Pillar 3 disclosures of climate-related financial risks. The ISSB standards provide a baseline for climate risk disclosures by corporates and are being adopted by various jurisdictions. A review of the implementation of current climate risk disclosure rules for listed companies across jurisdictions reveals significant differences in approaches and methodologies. The ISSB and the EU standards require disclosure of ESG (Environment, Social and Governance) risks and cover scope1, 2 and 3 emissions, whereas the US Securities and Exchange Commission (SEC) rules focus only on climate risks. The SEC consultative paper covered all emissions (scope 1, 2 and 3) but the final climate disclosures rules required disclosures of only scope 1 and scope 2 emissions. It is noteworthy that, as per CDP estimates, for some sectors scope 3 emissions are around 90 per cent or more of the total emissions (financial services including banks, almost 100 per cent, oil and gas around 90 per cent of total emissions). The SEC Final Rules, adopted in March 2024 were challenged in court and SEC stayed the rules voluntarily in April 2024 pending judicial review. Companies in California covered under Senate Bill 253 are required to disclose scope 3 emissions in addition to scope 1 and scope 2. The ISSB Standards focus on single financial materiality, but the EU rules cover double materiality (both financial and impact materialities).

As already mentioned, the consultative document issued by Basel Committee is specifically designed for banks, keeping in view their unique characteristics: high leverage, acceptance of public deposits and bank failures generating negative externalities. In the author’s opinion, the mandated qualitative disclosures are essential for a proper understanding of the bank’s management of climate-related financial risks from a governance, risk management and strategy point of view. Given the uncertainties relating to climate-related financial risks and their materialisation over a long-term horizon, it is important to disclose a bank’s strategic approach(es) to navigate these risks. The disclosures relating to climate-related risk drivers, including physical risks and transition risks, will enable the market participants to understand the ‘exposure’ of a bank to climate-related financial risks and do not imply that these climate-risk exposures have crystallised into ‘financial losses’; any such inference is not appropriate. To conclude that these disclosures will be misleading to market participants is to underestimate their ability to analyse and assess the true meaning of the disclosures being made. It is acknowledged that climate risk data collection is in its early stages, but the disclosures will also act as an incentive for banks and supervisory authorities to further refine their methodologies. The Basel Committee has stated that the Pillar 3 disclosure requirements for climate risk will be an iterative process and that the framework incorporates a reasonable level of flexibility. This is reflected in permitting the use of national discretion for the following disclosures: (i) real estate exposures in the mortgage portfolio by energy efficiency level; (ii) emission intensity per physical output and by sector; and (iii) facilitated emissions related to capital markets and financial advisory activities by sector. The disclosures proposed in the consultative document will enable the markets to understand a bank’s exposure to climate-related financial risks and thereby foster market discipline.